Ring-fencing need not hem banks in
The UK's Independent Commission on Banking gives proposals for how banks should ring-fence their businesses, but they have left some room for manoeuvre, and banks must take advantage of this by developing new strategies and looking at different ways to maintain a competitive edge.
When designing their ring-fences to comply with the UK's Independent Commission on Banking's recommendations, the country's banks will need to decide, subject to legislative or regulatory restrictions, where activities are conducted (the ‘location’) and the degree of separation between the ring-fenced bank and the wholesale/investment bank (the ‘height’).
The ICB has predetermined the location of many activities, namely:
- Mandated services. Those services that 'must' be in the ring-fence (the provision of retail and small and medium-sized enterprise deposits and overdrafts).
- Prohibited services. Those services that 'must not' be in the ring-fence (wholesale/investment banking and services to non-European Economic Area customers).
- Ancillary services. Risk-management and other essential services required for the ring-fenced bank to function.
In addition, while not prescribing complete separation, the ICB has set out guidelines in determining the height of the ring-fence, including:
- Governance and operational links. The ring-fenced bank should to all intents and purposes be ‘distinct’. This includes having a distinct governance structure, operational infrastructure and regulatory obligations.
- Economic links. Restricting financial exposure to the wider corporate group and ensuring economic activity is on an arm’s-length basis.
In terms of location, the main decision point is therefore likely to be where to put the corporate banking business as this is where the ICB has left some flexibility. In terms of the height of the ring-fence, there are also decisions to take with regard to the operating model and how best to retain economies of scale while meeting the requirements.
Capital and funding focus
The strategic analysis to support the design of the ring-fence will focus on the capital and funding implications which are likely to be the most material influence on the final decision on the location of activities.
Both entities will need to meet regulatory capital and liquidity requirements. In addition, both will need access to external funding and will therefore need to actively manage rating agencies and the broader market. These factors will therefore need to be modelled by banks and analysed on at least a product basis and a customer basis. This analysis should be undertaken early to help shape the initial response but it is likely that it will need to be revisited as rules become finalised and the shape of the economy and bank balance sheets change over the coming years. The analysis also needs to incorporate the changes being implemented through Basel III/Capital Requirements Directive IV.
In addition, banks will need to consider other factors, including:
- Product strategy. Given the higher capital and funding costs, the profitability and return on equity for banking products will need to be reviewed and decisions taken on the optimum mix and location of business.
- Delivering for the global customer. This is an area where non-UK domiciled banks will potentially have a significant advantage, in particular when dealing with global corporate clients.
- Competition. Ring-fencing could also lead to additional retail competition in the UK market from passported European banks, which are not subject to the rules and can therefore offer retail customers better deals (although without the protection afforded by the ring-fence).
- Other regulation. There is a raft of change in the pipeline and all decisions should be taken based on an aggregate view of the impacts.
What and how
Once the analysis is complete and the ring-fence is designed, the banks will need to consider whether they wish to move the location, change jurisdiction, sell or run-off any of the different businesses given the new economics and the potential competitive disadvantages. Another factor in this decision will be the cost to implement and the cost to maintain, in particular given the context of the rest of the regulatory change agenda in the next five years.
Banks therefore have a number of big decisions to make in an environment that remains uncertain. What is clear, however, is that the ICB proposals will require significant investment to implement, but those who move first and move strategically are likely to gain a competitive advantage come 2019.
Vishal Vedi is a partner and Tom Spellman is a director at Deloitte.
